This post is about how Switzerland has successfully employed an innovative system of incentives to encourage its citizens to reduce the amount of garbage they create. Just three weeks in this amazing country and I can already see why it earned the highest score in last year’s Environmental Performance Index.

In the AP and IB Economics units on market failure, we study the concept of negative externalities, which exist when the behavior of one individual or firm creates spillover costs to be faced by other individuals or society as a whole. A simple example is a factory that dumps waste in a river. Clearly, disposing of its waste in such a manner poses little or no cost on the factory owners, but significant costs on downstream users of the river’s water. A community that wishes to use the river for drinking water must now install expensive filtration and purifying systems just to make the water usable. The factory has kept its own costs down by externalizing the cost of filtration by passing it on to downstream users.

Spillover costs exist on micro levels as well. While it is easy to see how a large factory creates negative externalities, it is often harder to imagine how we as individuals create spillover costs for our neighbors and society in our everyday actions. The stark truth, however, is that an individual’s behavior, multiplied by millions upon millions of individuals making up a citizenry, can have as great if not greater negative impacts on the environment and society as the negligent behavior of one firm.

Here in Switzerland, the behavior of each individual citizen is subject to unusually strict scrutiny. No, Big Brother is not watching, as you may be thinking, (however, I have heard stories of snoopy neighbors alerting the police upon witnessing the most minor of infractions by a fellow citizen), rather, one finds it in his best economic interest to strictly monitor his own behavior down to the finest detail. Allow me to explain what I mean.

Let’s take garbage for example. The definition of garbage in Switzerland is very different from that in the United States. Where I’m from, garbage is anything that you can’t use anymore. You throw it “away”, put it on the curb and it disappears.

A garbage bag in the US is usually a 40 gallon (160 litre) plastic bag that could fit an entire family inside, and the typical American family probably produces two to three bags worth of “garbage” each week, which conveniently disappears in the wee hours of the morning to be taken “somewhere”, which most Americans don’t know or care to know where that is. How much does it cost an American household to dispose of this voluminous quantity of garbage? Well, the bags cost around 18 cents each, and monthly removal services vary depending on the community, but are typically a flat rate for almost any amount of garbage.

In the United States, it is very easy for individuals to pass the true cost of their garbage disposal onto society as a whole. It doesn’t matter all that much whether you put one tiny plastic bag on the curb or a half dozen 40 gallon bags on the curb, you are going to generally pay the same amount for collection regardless. The result of such a system is that the typical household has no incentiveto reduce the amount of garbage that it produces. Logically, Americans are inclined to over-consume and produce copious amounts of garbage in the absence of any significant system of incentives in place to encourage waste reduction.

So, what’s different about Switzerland? It’s all about incentives. Let me explain. Here, you don’t pay a flat rate for garbage removal. In fact, you don’t HAVE to pay anything for garbage removal! Oh wow, you say, it’s FREE? In fact, quite the opposite is true. You don’t have to pay anything for garbage removal as long as you don’t create any garbage. In other words, you only pay for what you throw away.

Unlike in the US, here a typical garbage bag here is a 35 litre plastic sack, only slightly larger than a plastic grocery bag. Each village requires its citizens to buy official garbage bags for that community, and each individual bag costs anywhere from $1.50 – $2.50. A role of ten 35 litre bags can cost around $25.

When we consider that anything a household wishes to throw away must be put in an official village garbage bag which itself must be purchased for $2.25, and we know that a typical 40 gallon (160 litre) garbage bag in the US costs just $0.18, we can easily calculate and compare the costs of garbage disposal to both US and Swiss households.

In Switzerland: 100 litres of garbage costs $6.40 to dispose of

In the US: 100 litres of garbage costs a little over $0.11 to dispose of

In other words, garbage removal costs Swiss households around 57 times as much per litre as it does Americans, when we consider the price of garbage bags alone.

Clearly, Swiss households are given a significant incentive NOT to create garbage. So what DO the Swiss do with lots of their waste? Recycle it, of course! See, here in Switzerland all recycling is free. The villages even offer free curb side pick-ups for all recyclable materials.

A simple system of incentives (and dis-incentives) is the secret to Switzerland’s environmental success. Other systems are in place to encourage citizens to use public transport, tread lightly while hiking in the outdoors, conserve energy and water at home, and behave in other environmentally friendly ways, but I’ll save my discussion of those items for another time, once I figure out how to reduce, re-use and recycle all my own “garbage” here in Zurich!

Discussion Questions:

How does Zurich’s system of garbage collection “internalize” the “externality” associated with household consumption?

Incentives matter. This is a basic economic concept that can be used to fix many of the environmental, social, economic and health problems faced in society. Identify one way your parents have used incentives to try to get you to do something or NOT do something they think you should or shouldn’t do.

Discourage what society want less of, encourage what society wants more of. Identify and discuss one example of a market in which a government (local or national) uses incentives to discourage certain behaviors, and one example of a market in which incentives are used to encourage certain behaviors.

In the fall of 2007 I was living in Shanghai, China. At the time, oil prices were hitting record levels world wide, leading to rising petrol prices for drivers in most places. However, at the time, I began witnesing an unusual site on my taxi rides into the city of Shanghai: as our taxi passed petrol station after petrol station, I observed dozens of blue trucks (the ubiquitous medium of transporting good from Shanghai’s factories to her ports) spilling out of gas station parking lots into the road, apparently queued, waiting for a spot at the pump. I had never seen such long lines at any of the petrol stations around Shanghai before, and I began to wonder as to the reasons for these crazy long lines!

Well, an article at the time helped solve the riddle of the long lines. As it turns out, there was a simple explanation rooted in the principles of supply and demand that any first semester AP or IB economics student would understand! The Chinese government had been forced to ration petrol (limiting the amount that a driver can buy at one go) due to the shortages resulting from the government’s price controls in the petrol market.

Truck drivers reported long queues at petrol stations along a national highway linking Fujian and Zhejiang provinces, with each truck getting 100 yuan ($13) worth of diesel, or around 20 litres, per visit at a state-run station and 40 litres at a private kiosk…

“What’s wrong with the oil market? Our drivers had to queue the whole night for only a small amount of fill, slowing the traffic by almost one day,” said Gao Meili, who manages a logistics company.

China is a major importer of oil. With an economy growing around 12% in 2007, much of the country’s growth depended on the availability of crude oil at reasonable prices, which China’s oil refining firms turn into diesel and petrol, needed to get Chinese manufactured products from factory to port and from port to overseas consumers.

The problem with the oil market in China, however, was that as “Chinese refiners cannot pass the souring crude costs on to consumers.” Oil is an input needed to make a finished product, diesel. As the price of oil rose in 2007 (it reached a record of $92 per barrel in October of that year), the resource costs to petrol and diesel producers also rose, shifting the supply of petrol and diesel to the left, putting upward pressure on the equilibrium price. As a first semester AP or IB student knows, resource costs are a determinant of supply, and as oil (the main resource in the production of petrol and diesel) increased in price, the supply of these important commodities invariably decreased.

In a free market, a decrease in supply leads to an increase in price. Herein lies the answer to the riddle of the long lies at petrol stations in Shanghai: the Chinese petrol and diesel market is not a free market. The government plays an active role in controlling prices paid by consumers for the finished product refiners are producing, petrol fuel:

As the costs to petrol and diesel producers rose in 2007, the government in Beijing took the side of consumers and forbade fuel producers from raising the price they charge consumers. The Chinese government essentially imposed a price ceilingin the market for petrol. A price ceiling is a maximum price set by a government aimed at helping consumers by keeping essential commodities like fuel affordable. As we have learned this week in AP and IB Economics, price controls such as this end up hurting BOTH producers AND consumers, since they only lead to a dis-equilibrium in the market in which the quantity demanded for a product rises while the quantity supplied by firms falls. The shortage of petrol and diesel resulting from the government’s price control are the perfect explanation for the long lines of blue trucks and motor scooters at all the gas stations in Shanghai during October of 2007.

So why, exactly, does the government’s enforcement of a lower than equilibrium price result in such severe shortages that truck drivers are only allowed to pump 20 litres of petrol per visit and made to wait hours each time they need to refill? Below is a supply and demand diagram that illustrates the situation in the Chinese fuel market in 2007:

In the graph above, the supply of petrol has decreased due to the increasing cost of the main resource that goes into petrol, oil. This decrease in supply means petrol has become more scarce, and correspondingly the equilibrium price should rise. However, due to the government’s intervention in the petrol and diesel markets, the price was not allowed to rise and instead remained at the maximum price of Pc.

At the government-mandated maximum price of Pc, the quantity of fuel demanded by drivers far exceeds the quantity supplied by China’s petrol producers. The result is a shortage of petrol equal to Qd-Qs.

The government’s intention for keeping petrol prices low is clear: to make consumers happy and keep the costs of transportation among China’s manufacturers low so as to not risk a slow-down in economic growth in China. However, the net effect of the price controls is a loss of total welfare in the petrol market. Notice the colored areas in the graph above. These represent the effect on welfare (consumer and producer surplus) of the price control.

The total areas of the green, orange and grey shapes represent the total amount of consumer and producer surplus in the petrol market assuming there were NO price controls. At a price of Pe, the quantity demanded and the quantity supplied are equal (at Qe) and the consumer surplus and producer surplus are maximized. The market is efficient at a price of Pe. Neither shortages nor surpluses of petrol exist.

However, at a price of Pc (the maximum price set by the government), the amount of petrol actually produced and consumed in the market is only Qs. Clearly, those who are able to buy petrol are better off, because they paid a lower price than they would have to without the price ceiling. But notice that there is a huge shortage of fuel now; many people who are willing and able to buy petrol at Pc simply cannot get the quantity they demand, because firms are simply not producing enough!

The total consumer surplus changes to the area below the demand curve and above Pc, but only out to Qs. The green area represents the consumer surplus after the price control. It is not at all obvious whether or not consumers are actually better off with the price ceiling.

The total producer surplus clearly shrinks to the orange triangle below Pc and above the supply curve. Petrol producers are definitely worse off due to the government’s action.

So how is the market as a whole affected? The black triangle represents the net welfare loss of the government’s price control. Notice that with a price of Pe, the black triangle would be added to consumer and producer surplus, but with a disequilibrium in the market at Pc, the black triangle is welfare lost to society.

Price controls by government’s clearly have an intended purpose of helping either consumers (in the case of a maximum price or price ceiling) or producers (in the case of a minimum price or price floor). But the effect is always predictable from an economist’s perspective. A price set by a government above or below the equilibrium price will always lead to either a shortage or a surplus of the product in question. In addition, there will always be a loss of total welfare resulting from price controls, meaning that society as a whole is worse off than it would be without government intervention.

Discussion Questions:

Why has the supply of petrol decreased?

With a fall in supply of a commodity like petrol, does the demand change, or the quantity demanded? What is the difference?

Define “consumer surplus” and “producer surplus”. Why does a government’s control of prices reduce the total welfare of consumers and producers in a market like petrol?

How would a government subsidy to petrol producers provide a more desirable solution to the high oil prices than the maximum price described in this post? In your notes, sketch a new market diagram for petrol and show the effects on supply, demand, price and quantity of a government subsidy to petrol producers. Does a subsidy create a loss of welfare? Why or why not?

Because if it were, there would be no debate at all. Immigration, from an economic standpoint, is simply the flow of labor from one geographic region to another. I’m not talking about the kinds of immigrants who arrive in America or Switzerland or the UK as refugees fleeing political, religious, gender or racial persecution. Such asylum seekers have motives that are entirely non-economic for fleeing their homelands. I’m talking about the millions of people every year pack up their homes and seek a new life in a new country for economic reasons.

America has been called the “land of opportunity”, and for nearly five centuries now the opportunities the New World has had to offer have attracted immigrants from all corners of the globe. First it was the Spanish and the Portuguese who came in conquest in search of gold and silver. Later came the pilgrims seeking religious freedom, and after that the Irish, Italian, Germans, Russians and countless other Europeans seeking the economic opportunities offered by the construction of railroads, homesteads on the Great Plains and gold in the mountains of the West. Chinese arrived by the millions from the 1850’s through the turn of the 20th century, and over the past hundred years America’s racial, ethnic, religious, linguistic and cultural fabric has been enriched by the arrival of millions upon millions of people seeking the economic opportunities America has had to offer. The opportunities of the 21st century no longer involve the hope of striking gold or working on the railroad, rather they exist in industries such as software engineering, medicine, scientific research, finance and, yes, agriculture and construction.

It is interesting to me that in the United States today, American citizens and politicians seem to be as angry as ever about the seemingly endless flow of “illegals” flooding across the American border, bringing with them crime and contributing to unemployment among American workers already struggling to find jobs during the country’s deepest recession in decades. If you believe politicians like the governor of Arizona, Jan Brewer, this “invasion” of illegals from south of the US border is simply tearing apart the fabric of American society. Her state has even gone so far as to pass a law requiring police officers to require anyone who they suspect of being “illegal” to present proof of their legal status upon the officer’s request. Other attempts by states to crack down on illegal immigration include laws forbidding landlords from renting apartments to illegal immigrants and on a national level there is a major push to change the US constitution, in which the 14th Amendment states that any child born in the United States is automatically a US citizen. Imigration opponents claim that millions of Latinos enter the US illegally to have babies, which they call “anchor babies”, who become US citizens and then, supposedly, later in life, help their parents become legal US residents.

The protest against illegal immigration has dominated the right wing agenda in America lately, and has brought angry Americans to the street for rallies across the country aimed at sending illegals “back to where they came from”.

The irony of the whole situation is that today, in the midst of the Great Recession, immigration rates are falling rapidly. The number of immigrants entering the United States illegally has actually fallen by 67% in the last few years, from 850,000 per year between 2000 and 2005 to under 300,000 in 2009. Even more ironically, the number of illegals leaving the United States now actually exceeds the number entering the US, meaning that the total number of illegal immigrants (around 11 million in 2009) is decreasing and is lower now than it has been for much of the last decade. The Washington Post presents the facts:

From an economic perspective, the backlash against illegal immigration to the United Sates right now is perplexing and frustrating. Americans currently find themselves in a dire economic situation in which over 8 million people have lost their jobs, the unemployment rate is stuck at a historic high of nearly 10%, and discouraged workers have dropped out of the labor force at alarming rates, meaning that almost one in five Americans is either unable to find work or has given up the search. Clearly there is much to be upset about.

But all the facts above send a clear message to potential illegal immigrants to America, as well as to those who are already here! The message is, “DON’T COME!” (or for those who are already here, “maybe this is a good time to leave!”). Some of the decrease in the flow of illegal immigrants can probably be attributed to tougher border security and increased enforcement of the existing immigration law. But it’s more likely that the decrease in the illegal population is an economic phenomenon. Here’s why:

America purportedly practices a system of economics known as a free market. The fundamental characteristic of the free market system is that resources are allocated efficiently when they are allowed to flow from markets in which they are in low demand to markets in which they are in high demand. Price is the signal that tells resource owners where their resources are demanded the most. When we are talking about immigration, the resource that is flowing from market to market is labor. In a free market economy, there should be no government controls over the free flow of labor from one market to another. When the price of labor in one market (say the apple industry in Washington State or the construction sector in Arizona) is higher than in another market (say the corn industry in Mexico or the retail sector in Guatemala), the signal sent by this imbalance of wages is that more labor is demanded in Washington and Arizona and less is needed in Mexico and Guatemala.

The imbalance of wages between the US and its closest neighbors leads to a natural inflow of labor from low-wage countries to the higher wage industries in the United States. It’s a form of osmosis, which according to Wikipedia is “the movement of water across a partially permeable membrane from an area of high water concentration to an area of low water concentration… which tends to reduce the difference in concentrations”. Instead of water, immigration is osmosis of labor. Labor is more abundant in Mexico and Latin America than it is in the United States. The flow of labor across America’s “semi-permeable” border with Mexico simply “reduces the differences in concentration” of labor between the US and its southerly neighbors.

Making it harder for immigrants to come into the United States does little to protect American jobs. One thing I teach my students is that in a world where labor is not able to be imported (i.e. one where immigration is stemmed or slowed down), we should expect to see capital exported. A higher border fence with Mexico or more immigration police or a repeal of the 14th Amendment may reduce the number of people coming to the United States to find work, but these barriers to immigration will do nothing to stop the flow of capital to Mexico and the rest of the low-wage world. If Americans want more jobs to be done in America, then they should embrace those who are willing to do them, otherwise those jobs can be exported to where the wages are lower and people are willing to do them. If labor is immobile, capital will grow legs!

The immigration debate is not an economic debate. It is a political one. From a purely economic perspective, with the efficiency of free markets as a guiding principle, the free flow of labor across national borders improves overall efficiency of both the countries from which the immigrants come and the country in which they arrive. American workers are only marginally affected by the presence of illegal immigrants in the United States. Several studies have shown that while employment among certain Americans is affected slightly, there is no evidence that illegal immigration puts downward pressure on American wage rates. Jobs that might not even exist in America without immigrant workers willing to work for low wages do get done thanks to immigration, and the American economy is stronger and healthier because of this. Without immigration, those jobs will still get done, just not in America! Or, if the jobs can’t be exported, they’ll get done but at a much higher cost, raising prices for American households and reducing the real income of the American people.

In economic terms, increased immigration allows the United States to have a comparative advantage in the production of a broader range of goods and services than it would have without immigration. Since in a global economy, what a nation’s economy produces is determined by what it can produce at the lowest opportunity cost, the more low-wage labor America has to employ, the larger it can expect its economy to be and the greater number of exports it can expect to sell to the rest of the world. Immigration is overwhelmingly positive for the American economy, even illegal immigration. If it weren’t illegal, it would happen anyway, just more of it, which again would only make the US economy stronger and its output greater.

Again, these are all mute points in the current American debate over immigration, because the fact is that the net flow of illegal immigrants is actually negative right now. NPR reports,

Signs are pointing to stabilization on the border… as a still-sputtering U.S. economy and high unemployment continue to contribute to the over-the-border slowdown. Estimates suggest that the U.S. economy has lost 8 million jobs in the downturn, including 4 million manufacturing and construction jobs over the past three years.

The free market offers the perfect solution to the illegal immigration debate in the United States. Let it be! If America doesn’t need more labor, then labor will not come to America, and some of that which is already here will leave. But once the US economy begins to recover and the demand for labor begins to grow once more, let it be! Instead of building higher fences and hiring more border police, find ways to make it easier for workers to enter the country and fill the jobs for which they are demanded. America will be stronger for it! After all, if we don’t embrace the inflow of labor, we better be prepared for an outflow of capital. And as even my first year IB Econ students can tell you, a decrease in the labor force and the amount of capital in a nation is a recipe for economic contraction, recession and declining standard of living among that nation’s people.

Is that the America we want to see in the future? Would America be the land of freedom and opportunity today if it had kept out immigrants throughout its history instead of embracing them and incorporating them into American society and the US economy? I doubt it. So, America, end the debate… because from an economist’s perspective, it was over before it even began!

Update:

Several people have left comments on my Facebook page about this post. Here are a couple of those comments:

From reader #1:

Good post! I’m curious since you didn’t specifically mention the main argument I’ve seen: Illegal immigration results in immigrants who consume more value in public services than they return to the public funds. What’s your take on that angle?

And from reader #2:

Very good and well thought out post. However, I disagree that it isnot an economic issue. In fact the major problem is that it IS an economic issue. Over 80 percent of their wages go back home – out of the country – and I’m not just talking about Mexicans. Additionally they go to the emergency room for most of their medical issues, even the common cold. They can have a $10,000 visit and never pay a penny – we have to pay for it. They get welfare, food stamps and much more – and we have to pay for it. Most of them have false IDs and Social Security cards so they pay no taxes.

Granted some of them do the jobs that most Americans won’t do – agriculture, sweat shops, etc. – but they cost us much more than they provide. 60 percent of the criminals in California jails are illegal and we have to support tham at an average cost of $30,000 per year each. Their families also collect welfare. Thousands of car accidents are caused by illegals each year who have no insurance – driving our insurance rates sky high.

Illegals are DEFINITELY an economical issue. By the way what is the first word in ILLEGAL alien – their very existance here is illegal. Also they are not illegal immigrants. An immigrant is one who goes through the proper channels and supports this country. The illegals do not do that. They protest that they are mistreated and insist that they be treated as citizens. Try to enter their home countries illegally and see how you are treated. America is heaven to ‘our’ illegals compared to virtually any other country in the world.

So, I felt obliged to reply to these comments, so here is my response!

Reader number #2, you have some fair concerns, but it should be pointed out that the industries immigrant workers support do pay taxes, and the revenues these businesses generate for the US economy using low wage immigrant labor is taxable income. Without the availability of cheap labor, many of these industries would fall to foreign competition or would simply pack up and move their operations to foreign countries. Without the income generated by these industries, the US tax base would shrink and there would be less to spend on all sorts of public goods for US citizens.

While you’re right that illegals do not pay income taxes and therefore are “free-riding” in a sense, it must be recognized that if they were here legally, they also would not pay income taxes, and in fact would be eligible for billions of dollars in federal tax subsidies and other transfer payments due to their low income (minimum wage?!) that they are not able to take advantage of due to their status as illegals. So couldn’t you argue that they’re costing American taxpayers LESS because they are here illegally?

And I don’t understand your argument that since they make up 60% of California’s prison population they are somehow taking advantage of the American taxpayer. If those spots were not occupied by “illegals”, are you suggesting there would be 60% fewer prisoners? Last I heard California was shortening sentences to make room for the long line of convicts who there is simply not room for in the state’s prison system! Wouldn’t taxpayers have to pay $30,000 a year for any prisoner, regardless of his nationality? I mean, if they were Americans they’d also cost $30,000 a year to support, right?

Reader #1, with regards to the lack of contribution to public funds, you must remember that most Americans earning below $40,000 per year effectively pay no income tax, and depending on the number of children they have and other factors may even be eligible for an earned income tax credit of thousands of dollars. Illegal immigrant workers earning minimum wage (or close to it), if they were to become legal taxpaying workers, would instantly add millions of low income workers to the tax system and thus add billions of dollars to government expenditures on EICs and other tranfer payments, as opposed to contributing positively to the country’s public funds like you suggest they might. I mean, sure, an immigrant working in Silicon Valley is a valuable contributor to the tax base, but one working for minimum wage on a farm will add nothing to the tax coffers, legal or not!

In addition to the earned income tax credit, as legal American workers they’d be eligible for welfare benefits, unemployment benefits, Medicaid, food stamps, subsidized school lunches and countless other transfer payments that would place a larger burden on the American middle and upper class tax payers.

Reader #2, illegal immigrants are not the only people in America who take advantage of the emergency room. Poor white Americans, not to mention the 49 million of us who are without health insurance, can walk into an emergency room just like the few million illegal immigrants can and walk out without ever paying a bill. Do you also want to kick the nearly 50 million uninsured Americans out of the country because they might take advantage of the Emergency room? Is a poor illegal immigrant any more likely to drive without car insurance than a poor American citizen? I don’t know, but I’d be interested to see some data on that.

Public schools are paid for by property taxes in most states. Immigrant workers supporting a family on minimum wage are never going to contribute much to property taxes, just as low income American households who rent their homes or own homes of low value will not pay much in property taxes. Yet their children still receive an education, don’t they? Should we deny all Americans who do not pay much in property tax access to public education? Besides, if a family or an individual pays rent, whether they’re citizens or illegal immigrants, their landlord is paying property taxes which go towards supporting public schools. Therefore anyone, legal or illegal, who pays rent is indirectly supporting public schools… so what difference does it make whether the renter is an American citizen or not?

Reader #2, one of the only reasons that 80% of illegal’s wages are sent home is because the US makes it so difficult for them to bring their families into the country with them. I think you misunderstood the whole point of my blog post. I did not intend to present an argument for more ILLEGAL immigration, rather I intended to present an economic argument for more LEGAL immigration. I think immigration reform that makes it easier for labor to flow across borders between the US and its immediate neighbors would alleviate much of the anti-immigration concerns of citizens like yourself. Yes, illegal immigration is ILLEGAL, so let’s make it easier for immigrants to come here legally, then we’ll have fewer criminals on our hands, and more valuable human capital to contribute to the strength of and increase the growth potential of the American economy.

I’m approaching this issue from a purely economic standpoint here, and from an economic perspective the benefits of more flexible international labor markets overwhelmingly outweigh the costs. Look at the EU and the 27 member countries which allow labor to move easily and efficiently across national borders. If immigrant labor was really as harmful as America claims it to be, then why has Europe embraced open borders and its economy has grown to exceed the size of the United States in the last decade? Sure, many Brits hate having Eastern Europeans in their cities “taking their jobs” and corrupting their culture. But the British economy (and those of Eastern Europe) are better off because of it.

Objective: To understand how productive resources, goods and services and money flow from households to firms and from firms to households through voluntary exchanges in a nation’s product and resource markets.

Introduction: This lesson simulates the circular flow of resources, goods and services in a nation with a closed economy and no government sector. The simple circular flow model re-created through this simulation can be graphically represented as follows:

Instructions: The teacher will need to prepare several resources before beginning the simulation. These include:

Money certificates: These should be printed on green paper (perhaps four certificates per page), then cut into strips approximately the size of a dollar bill. I recommend four “bills” from each sheet of paper. You’ll need a paper cutter to quarter the photocopied sheets once they’re printed. You should print at least 50 sheets of money, creating a total of 200 money certificates. On each certificate should be printed the words:

“This certificate is a money payment for a good or service or a productive resource. In the resource market it represents the wages, interest, rent and profits households receive as income for their resources. In the product market it represents the expenditures households make for goods and services.”

Resource certificates: On a different color sheet of paper, make approximately 40 copies of a page with the three resources on it, separated vertically: “Land, Labor, Capital”. Each resource should be on its own strip of paper. Make sure you create the same number of each of the three resources. For a class of 20 students, I would recommend making at least 50 copies of each resource (50 lands, 50 capitals, 50 labors, totaling 150 resources in total).

Product certificates: On yet a different color sheet of paper, print and make approximately 15 copies of a page with the words “Goods and Services” on it four times from top to bottom, so you have a total of 60 “Goods and Services” certificates. Again, use the paper cutter to quarter the pages so you have 60 strips with the words “Goods and Services” on them.

For a class of 20 students, you must create 20 different paper clipped bundles ahead of time. 10 of your students will be “FIRMS” and 10 will be “HOUSEHOLDS”. Each of the households will receive a bundle of resource certificates. Each firm will receive a bundle of money certificates.

10 Household bundles: Prepare 10 bundles of resources. Each bundle can contain a random combination of land, capital,and labor. It is important that some households receive far more productive resources at the start of the simulation than others. For example, you may give one student a bundle with 5 labors, 7 capitals and 8 lands. Another student may receive a bundle with 2 labors, 1 land and 1 capital. This may seem “unfair”, but will play an important role in your post-simulation debrief. Be sure to use ALL of the resources you printed out, so you are sure there is an even number of land, capital, and labor.

10 Firm bundles: Each firm is run by an entrepreneur. The entrepreneurs who manage each firm start with a different quantity of financial capital. Divide your 200 money certificates into 10 different bundles, some containing larger amounts of money than others. The “average” entrepreneur will have 20 money certificates to start, but be sure to give some firms far more than this and other firms far less.

The simulation: For the simulation, you will need a large open space. I recommend going outside where there are some trees you can tape signs to, or in a gym or a classroom with the desks moved to the center of the room.

Begin by asking students “Who are the two ‘stakeholders’ in a nation’s economy portrayed in the circular flow model?” Once they’ve identified “Firms” and “Households”, have a volunteer tape two signs on walls opposite from one another in your teaching area.

Next ask students to identify what it is that firms demand from households, and what it is that households demand from firms. Once they’ve identified “Resources” and “Products”, have a volunteer tape the signs for “Resource Market” and “Product Market” opposite each other in your area. You now have four signs taped to the wall: “Households” and “Firms” are across from one another, and “Resource Market” and “Product Market” are across from one another.

Next assign roles: Give each student a letter, either and “H” or an “F”. Half the class will become Households and will re-group at their sign, the other half of the class will be come Firms and meet at their sign. Explain to the Firms that they are entrepreneurs who want to start a business that will produce a good or service. As entrepreneurs, they are putting their own creative ideas towards a business venture, but must acquire land, capital and labor in order to begin producing their good or service.

Ask the Households what they want, and where they will get it. They’ll say “Products” and they’ll get them in the “Product Market”. Ask firms what they want and where they’ll get them. They should say “resources” and they’ll get them in the “Resource Market”.

Next discuss the motives of firms and households. The entrepreneurs and their firms are seeking to maximize profits in the Product Market, which they will do by minimizing their costs in the Resource Market. Therefore firms must try to acquire the land, labor and capital at the lowest cost possible and then sell their goods and services for the highest price possible. Households are seeking to maximize their incomes in the resource market in order to maximize their consumption of goods and services in the product market. Therefore households should try to sell their resources for the highest price possible and buy their products at the lowest price possible.

Ask the students: “Now we’re ready to begin our circular flow, but something is missing. What is it?”. They will know right away that “MONEY” is missing. At this time, distribute the different sized bundles of money to the entrepreneurs. Make each entrepreneur count his or her money so it knows how much it started with. This way each firm will know whether it earns a profit or a loss during the simulation.

Time to FLOW! First comes the RESOURCE MARKET. In order to produce one product, business owners must acquire three resources: one land, one capital and one labor. Make sure they know that they must have one of each to produce one good or service, so that firms do not go out an buy nothing but labor or nothing but capital.

The firms and the households must now meet in the resource market.

Give the firms five minutes to bargain for and acquire as many resources as they can from household with their limited financial capital.

Encourage firms to “shop around” until they find a household willing to sell its resources for the lowest cost, or until households find a firm offering the highest income.

Once a firm runs out of money, have the entrepreneur come to the “FACTORY” (this is you, the teacher) where the firm will exchange the resources it acquired in the resource market for “Goods and Services” certificates. Remember, one product (G&S certificate) costs three resource certificate, one of each of Land, Labor and Capital.

After 5 minutes the resource market is closed and firms must report to the teacher’s “factory” to turn their newly acquired resources into Goods and Services. Give each entrepreneur one “G&S certificate” for each bundle of land, labor and capital the entrepreneur acquired in the resource market. Households should return to their sign and count their money incomes and drool in anticipation as the firms produce their goods and services. Any resources unsold by households or unused by firms must be put aside, these may not be exchanged in the product market.

Time for the PRODUCT MARKET.

Remind the households what their motive is in the product market: to acquire the MOST goods and services possible, therefore spend all their money but try to get the lowest price possible.

Remind firms what their motive is. EARN A PROFIT! To do this they must now sell their products at the highest price possible.

Give the students five minutes to buy and sell goods and services. Encourage the households to “shop around” for bargains. Observe what prices products are selling for between different buyers and sellers.

At the end of five minutes, the product market is closed. Send firms back to their sign and households back to their sign.

Analyzing the results:

First ask the firms to count their earnings. Determine which firms earned profits and which firms earned losses.

Determine how many resourced went unsold in the resource market or were bought by firms and then were unable to be used to produce goods and services.

Determine how many goods and services went unsold in the product market. If all goods and services were sold, then determine how much money households had left over and were unable to spend.

Simulation debrief – Economic concepts to discuss: The following are just some of the economic concepts that you can discuss following your circular flow simulation. There may be others, but these are some of the most interesting and important.

The Circular Flow: Ask students what, exactly, was “flowing” in the circular flow.

Resources flowed from households to firms, were turned into goods and services, which then flowed from firms to households.

Money flowed in the opposite direction; first from households to firms in the form of Wages, Interest, Rent and Profit (the income payments for the four resources households owned), then from households to firms in the form of expenditures on goods and services, which translate to revenues from firms.

Efficiency and the PPC: Were there resources that households had in the beginning but were unable to sell in the resource market or resources that firms bought but were unable to use? The existence of unused resources is evidence that our “economy” was producing below its PPC.

Discuss with the class how the “unemployed or underemployed resources” represent an “excess supply” of productive capacity in the economy. The existence of unused resources is evidence that the price in the resource market was too high! If the price had been lower, then firms would have demanded a greater quantity of resources and this “excess supply” would have been eliminated.

The unused resources represent the inefficiency of the nation’s economy. If the market had been more efficient, then more resources would have been employed by firms and more goods and services could have been produced, meaning the economy would have been producing closer to its PPC.

Households with unemployed resources represent unemployment in the economy. There were mismatches in the resource market between firms and households, and the prevailing income level was too high, resulting in an excess supply of resources, i.e. a surplus of land, labor and capital.

Equilibrium price in the product market: It is possible that following the product market round, some households will have money left to spend yet firms will be sold out of goods and services. This is evidence that the price goods were going for was too low.

If households were willing and able to buy, but there was not enough product to sell, then we had excess demand in the product market. The quantity demanded exceeded the quantity supplied.

The price in the product market was too low. A price below equilibrium leads to shortages. If firms had known there would be households willing to buy, then they would have charged a higher price and the shortage would have been eliminated.

Inequalities in the distribution of income: Ask students why some households ended up with more goods and services in the end than others? Also, why did some firms end up with greater revenues than others?

Some households had higher incomes and thus enjoyed greater levels of consumption because they were endowed with higher quality and a greater quantity of resources to begin with. This is representative of the real world in which not all households have the same education levels, own the same amount of land or have the same amount of financial capital as others. Those with the greatest quality and quantity of resources earn higher incomes in the form of wages, rent and interest and therefore enjoy a higher level of consumption.

Some firms ended up with higher revenues than others, which is probably because they started with greater financial capital. The entrepreneurs with access to more financial capital when starting their business were able to produce more products and earn higher revenues. But an entrepreneur’s having access to more money in the beginning did not guarantee he or she would earn profits! It’s likely that even the smallest firms were able to earn profits, if they were good at negotiating their costs down and their prices up.

Competition and “creative destruction”: Some firms will make losses while others make profits.

Firms that earn big losses will be forced to shut down or become smaller, because they’ll be unable to buy as many resources nor produce as much output in the next round of the circular flow.

Firms that earn larger profits will be able to expand and grow since they can reinvest their profits into more inputs and greater output in the future.

Competition forces firms to be as efficient as possible. Only firms that produce in the lowest cost manner can survive in a market economy. This is good because it assures that resources will not be wasted and output will be maximized as firms pursue their ultimate motive of profit maximization. I call this Economic Darwinism: “survival of the most efficient”, a key characteristic of market economies.

Other possible questions for discussion: The following questions can be distributed to students following the simulation and assigned as a reflection for the next class period, or put on the board and discussed as a class.

What, exactly, “flows” in the circular flow?

How is money spent by firms in one market end up being earned by firms in the other market?

What are the objectives of firms and households in a market economy?

Why did some households end up with more goods and services than others? Why did some firms end up with higher revenues or profits than others?

What role does self-interest play in a market economy?

What role does money play in the a market economy?

What would happen to the prices of resources and products if in the next round the amount of money firms started with doubled? What would happen if the amount of money were reduced by half?

Final thoughts: I have done this circular flow activity countless times with both AP and IB Econ students. Over the years it has evolved each time I’ve done it. I recommend you try it with your students and make small changes where you see they’re needed. Throughout the AP or IB course, however, I always find myself re-visiting our circular flow simulation in lectures, and students always recall immediately what I am referring to since they themselves were the households and firms engaging in voluntary exchanges motivated by their own pursuit of self-interest.

Additional note (and an acknowledgement): My teaching partner and occasional contributor to this blog, Joe Hauet, had the idea of giving the Firm owners the “entrepreneur” badge. My original simulation had “entrepreneurship” as one of the four resources owned by households and sold to firms in the resource market. But Joe keenly pointed out that in fact all firms are ultimately owned by households, and that it is the entrepreneurs who start the firms and then must acquire additional land, labor and capital from households to produce their product. So thanks to Joe for helping make this simulation better!

A classic method of teaching the basic economic concept of the production possibilities curve is to illustrate the relationship between a nation’s decision to invest in military goods versus civilian goods. The model typically includes two “products” that a nation can choose to invest in: guns and butter. The specific goods themselves are not so important, rather what they are meant to represent: the tradeoff any nation faces between allocating more of its scarce resources towards national defense versus goods and services that benefit the nation’s consumers.

Today the United States faces a very real version of the old “guns vs. butter” model. Rising global food prices have put public school districts in a bind: how to feed kids nutritious meals as the prices ingredients has risen at unprecedented rates:

Rising food prices are making it harder for schools to cook up ways to give kids the nutrition they need.

Right now, they’re taking shortcuts and shuffling ingredients to make up the difference, but that’s only a short-term solution with long-term consequences on the horizon.

“I’ve been in school service for 27 years and this is the worst it’s ever been,” said Sara Gasiorowski, food service director for Wayne Township Schools in Indianapolis. “I have never seen food prices jump up so far…”

Food prices nationwide have risen 4.5% between March 2007 and March 2008, according to the Bureau of Labor Statistics’ Consumer Price Index, with flour and eggs rising even more dramatically than milk. Grumbles said milk prices in her district are up 22% from last year, which means an increase of 3.5 cents for each of the federally required 16,000 half-pints she provides every day.

“For every penny on a carton of milk, it costs me $30,000 a year,” she said. “That’s $105,000 extra on my food bill.”

Flour prices have roughly doubled over the last year, according to Grumbles, to $19 per 50-pound bag. To make up for the difference, she substitutes canned peaches for fresh apples “to save a couple pennies” per meal, or she uses ground beef in place of chicken.

Unfortunately, federal funding for school lunches has increased at a much slower rate than cost to districts of providing those meals:

Federal reimbursement programs cover all or part of school districts’ lunch tabs. Congress lifts reimbursement rates every year, but Gasiorowski said it hasn’t been enough: “We need to be looking at an increase of 12% to 15%, instead of our usual annual increase of 2 or 3%.”

The current federal reimbursement program is based on household incomes; the poorest American students receive $2.47 of federal funding towards their “free lunches”, while students from the highest income bracket only receive $0.23 per meal. The problem is, the average school lunch now costs $3.10, so these days no one is actually receiving a “free lunch”, not even the poorest American students.

This article struck me in that is truly does illustrate the concept of tradeoffs as illustrated in the production possibilities curve. Society must allocate its scarce resources towards the goods and services it deems most desirable based on the needs of its citizens. Complications arise in this basic model, however, when government is involved.

The commitment to subsidizing school lunches is based on the idea that if the responsibility of feeding American school children were left to the free market, resources would surely be underallocated towards nutritious meals, representing a market failure. School lunches are a merit good, meaning they would be underprovided by the free market, since without public provision and support, millions of American children would come to school every day without nutritious meals to get them through the day.

National defense is another service that governments find it necessary to provide. If it were left completely up to the free market, national defense would probably not be provided at all. Instead, only individuals who could afford it would hire private security forces to protect their property. To protect a whole nation, however, government provision of defense is a necessity.

Clearly, both “guns” and “butter” create benefits for society. Among the countless other goods and services the government provides or supports the provision of, the United States faces a tradeoff arising from the scarce resources at the government’s disposal. Currently, the US government spends far more on its military ($660 billion in 2010!) than it does on lunches for American school children. Clearly, military spending is necessary, but it may be that in the tradeoff between these two important services more resources should be allocated towards “butter” at a period in the US economy when low income households are finding it harder than ever to provide their children with one of life’s most basic necessities, nutritious food.

Discussion Questions:

What do “guns and butter” represent on the PPC above? Why have economists found it useful to use these two goods on their analysis of the tradeoffs faced by nations?

Why doesn’t the United States just make all school lunches FREE for all American school children? Wouldn’t that make sense? Give an economic argument against this suggestion.

Why does the government feel it necessary to allocate any resources towards school lunches? Shouldn’t the government just let American families provide their own children with lunch?

Say the US government decided to increase its provision of both national defense and school lunches, without reducing its provision of some other good or service. How would it do this? Why wouldn’t the government do this?

Update: I received an email message from a reader about the above blog post:

I have to say that your “guns and butter” diagram is “interesting.” I am not clear on why the United States should spend vastly more on school lunches than on defending the free world While government provided school lunches may have a place, most Americans feed their own children and do not depend on Federal financing.

Where did you get the notion that feeding our children would be “under-provided by the free market”

Here was my reply to this reader. I’m posting it here because I want to make it clear the the diagram above is not meant to make any political statement about US military spending:

Hello,

Actually, the PPC was included simply to illustrate the basic tradeoff that society faces when it chooses how to allocate its scarce resources.

Having taught at least for a short while in public schools, I can say that nutritious lunches are definitely “underprovided” by the free market, that is, many students in poor communities in America depend on the “free and reduced” lunches that are provided through federal and state funding programs… I once volunteer taught in a poor Elementary School in Spokane, Washington where 40% of the students ate only two meals a day, both provided free by the school district: one at 8 in the morning, one at noon. Many of these children had parents who were poor, unemployed, often addicted to drugs, who failed to put any food on the table whatsoever.

In other words, I do think that nutritious meals are a “merit good” which by definition is one that is underprovided by the free market, therefore requires subsidies from the government. Otherwise, why would the government offer such subsidies at all, if these meals were something the free market could adequately provide on its own?

Again, I was not making any political statement with the graph, only pointing out the basic economic concept of tradeoffs and the idea that society must allocate its scarce resources towards an “optimal” combination of goods and services. The article indicates that in this time of rising food prices, not enough of America’s resources are going towards providing nutritious meals for school children, indicating that a movement along the PPC might be in order. The degree of such a move is irrelevant, only the fact that a movement must occur if nutritious meals are to continue to be provided. In fact, the x-axis could have represented any other public good the government provides for society, I chose “military spending” so that the current example was consistent with the classic example of “guns vs. butter”.